A Priceless Contradiction

In it to stay but not willing to make the long-term play

A decade ago when one encountered a prospective buyer who was willing to offer only half of what they thought their own business was worth, such buyers might be dismissed as non-consolidators and/or disingenuous. When bolder distributors made compelling offers and reaped the rewards of consolidation, it was difficult to have much sympathy for these deal-missers. The gap between what these individuals thought their targets should be paid and notion of their own business’ worth was too glaring to be accepted. Today, it’s different. Today there is another class of buyers who are only willing to go halfway, but I have sympathy for these buyers.

I can have sympathy for the distributor who misses a crucial deal based on any number of reasons. I just can’t muster much sympathy when the reason for missing the deal is a financially baseless value gap created by a would-be acquirer’s notion of self-worth and their perception of a target’s value. However, when a buyer’s reluctance is based on their own financial limits, and not their limited perception of a target’s worth, it’s easy to have sympathy given that very real and practical limitation. That said, I would press any distributor presented with an acquisition opportunity to give the question of their financial limits deep consideration because passing on an acquisition can have fateful consequences. A lot of those deal-missers from the last decade aren’t in the industry anymore.

Presently large value gaps are thwarting potential consolidations. This is particularly true for smaller deals. I’d like to pause and acknowledge that part of the gap is seller driven, and then set the seller portion aside because I want to talk about an issue tied to the buyer’s perspective. I want to address the potential conflict between an owner’s desire to stay in the business and their willingness to take on the long-term risks of a substantial acquisition.

I have encountered numerous owners who see a future that mandates grow or go. They acknowledge this imperative. They want to stay in the business and they would very much like to grow via acquisition. However, when they are presented with a consolidation opportunity they fail to pursue the acquisition with appropriate zeal. Higher purchase prices and industry trepidations combine to supplant the owner’s growth ambitions. Effectively these owners decide they will stay in the business for the foreseeable future (aka the long-term), but knowingly pass on doing exactly what they know they need to do to thrive in the long-term.

Beer distributorship prices have risen substantially over the last 10-15 years. Two corollaries of the increased prices are longer payback periods and smaller margins of safety. For buyers the net impact of higher prices are greater financial risks endured over a longer time, and everything else being equal, lower returns.

Current pricing is such that digesting debt from a major acquisition could take more than decade. 10+ years of debt service becomes progressively less appetizing as one goes from their 30s, to their 40s, to their 50s, and beyond. An individual with 15 years to retirement often isn’t eager to spend the last two-thirds of their working life sweating debt service. They’d prefer to just sweat what they absolutely have to – industry threats and supplier relationships. This mindset is understandable, but is it a viable course of action? For many smaller distributors and even some larger operations I expect the answer will turn out to be no.

I believe this mindset is potentially perilous. It’s like dropping into a prevent defense at the beginning of the fourth quarter. You stop playing to win and start playing not to lose. You stop being aggressive and instead start playing it safe. That’s when the opposition starts to pick you apart. The plan is to hold the lead and run out the last fifteen minutes. The result of this overly cautious strategy is often the forfeiture of a healthy lead, followed by a shocking defeat, and profound regrets. An analogous fate awaits the owner who decides to audible out of the acquisition game and ride out the next 15 years of beer industry changes.

The industry faces numerous uncertainties but some sustained trends and informed commentary tell us at least three things:

  1. Retailers will want more from distributors;
  2. Distributors are going to handle more products;
  3. Suppliers are going to reach into distributor profits.

Without considering these three items the typical distributor’s future will likely include low volume growth, modest price increases, and ever growing operating expenses. The net result is modest real earnings growth – before accounting for the items above. Growing scale through acquisition can be the only way to offset these additional costs / investments and produce a healthier and more sustainable earnings trend. Yet, some of those who are fortunate enough to get a look at acquisition don’t pursue the opportunity. The notion of debt kills the acquisition idea.

I have seen owners terminate their pursuit of an acquisition at a very early stage. Distributors generally want to get a look any deal, so they typically don’t balk at debt initially. It’s only after they take their first look at the acquisition and contemplate making a real offer that millions of dollar in debt becomes real, and that is exactly when some owners decide they aren’t willing to take on the debt.

Understand that I am not talking about the owner who drops out of a bidding war because pricing gets too high. I am talking about the owner who drops out the moment acquisition risks become real in their mind. They simply decide $X million of debt is too much for them. They never really dig into the opportunity. They don’t look at synergies. They don’t look at actual debt service. They don’t look at their margin of safety. They just don’t feel good enough about the next ten years to even consider taking on that kind of debt. So that is where their consideration of the acquisition ends. It’s over before they even come up with an offer.

It occurs to me that the reluctance of some would be buyers to generate a purchase offer could be linked to a reluctance to face their own future. If one pursues an acquisition and discovers the only purchase price they find palatable is one based on a weak or highly discounted earnings stream, then certainly there are implications for their existing business. If a distributor finds they are too concerned about the industry’s future to do an acquisition, yet they plan to stay in business another 15 years, there is a conspicuous rational inconsistency between those two positions.

One morning at a Holiday Inn Express buffet I came up with a psychological reason for this inconsistency. The owner doesn’t price the acquisition because they don’t want to contemplate the value of their own operation and their decision to stay in the business. They acknowledge the industry’s grow or go imperative but they aren’t willing to accept the implications of their decision not to grow by acquisition. Consequently, they don’t put a number on either the buy or sell side of the equation. They decide that prices are too high and the industry is too risky to do an acquisition, but the industry is too good to be a seller. It’s a priceless contradiction.

Three M&A related articles are included in this quarter’s Random Links. These articles offer business owners a variety of strategic insights. One article shows that an acquisition strategy based on a series of smaller deals tends to be more successful than a large acquisition strategy. A second addresses the importance of growth when it comes to driving value. The third details how growth can be found in strategic M&A. Taken together there is a suggestion for beer distributors. If you want to increase your business’ value significantly then you need to grow, and growth on that scale will require a strategic acquisition or acquisitions.

These days I have deep sympathy for the intense conflict between an owner’s desire to stay in the industry and their reluctance to swallow a major acquisition. I am particularly sympathetic to the circumstance of smaller wholesalers. Smaller distributors really don’t have a strategy option that involves a series of smaller deals. They don’t have a collection of acquisition targets that are only 30% of their size. Their only acquisition opportunity might be a target larger in size, and that means big-time leverage.

At the end of the day many a smaller wholesaler can find they are simply not in a position to be a consolidator. That’s just a harsh reality. There is no shame in walking away from an acquisition after a thorough look, but missing an opportunity because you weren’t willing to dig in is tragic. It is particularly tragic these days with banks lending money so cheaply. If they were to delve, a lot of distributors would discover their financial capacity is greater than they think. The deal can get done with an adequate margin of safety.

Planning to stay in the industry and failing to explore consolidation opportunities is paradoxical and perilous. If you are too skeptical about the industry and your ability to service acquisition debt to pursue a consolidation opportunity, then you need to ask yourself two questions. Are you correspondingly skeptical about you business’ ability to generate earnings for next 15 years? And, do you think your business will and retain its value over the next 15 years?

If you find that you are too skeptical about debt service to do a deal, but perfectly confident in your ability to ride out the next 15 years, then I suggest you have an inconsistency to reconcile. Putting numbers on both the buy side and sell side of your business can help you resolve the inconsistency. It won’t resolve the tension caused by the grow or go imperative, but you won’t be trapped in a priceless contradiction.

2 comments

  1. In some cases, the premium is not so much bynuig incentive but to pay off the more onerous of debts the other company incurs. Sometimes the merger bargaining involves discussion of what to do with the debts. Mergers can be a combining of peers, but usually a company subsumes another. The company taken over often had inferior resources to work with, including capital and debt issues. I’ve seen things where some units, say a region of stores were to be sold to pay off a debt issue that the bynuig company found disagreeable. Of course, they will also do that for other issues, such as one store chain I know sold its stores in a certain state because the union contract there held wages too high for their preferred model.

  2.  What to the trader is economic irrationality is to the hierarchically rational saint the acceptable price of keeping the society in a stable state of fallenness. Economics is conducted in ways that prevent it from falling further through  more-than-necessary debasement of the virtuous by the venal. The trader apologizes and acknowledges his sinfulness here, and minimizes the damage he does to the priceless values.

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